DotCom Mania: The Rise and Fall of Internet Stock Prices

Abstract

This paper provides one potential explanation for the rise, persistence and eventual fall of internet stock prices. Specifically, we appeal to a model of heterogenous agents with varying degrees of beliefs about asset payoffs who are subject to short sales constraints. In this framework, it is possible that "optimistic" investors overwhelm "pessimistic" ones, leading to prices not reflecting fundamental values about cash flows summarized by aggregate beliefs. Empirical support for this explanation is provided by exploring the behavior of internet stock prices during the period January 1998 to November 2000. In particular, we document four important elements to our story: (i) the high level of internet stock prices given their underlying fundamentals, (ii) responses of stock prices to a shift towards potentially optimistic investors, (iii) empirical results consistent with shorting being at its maximum possible level for internet stocks, and (iv) the eventual fall, or bubble bursting, of internet stocks being tied to the increase in the number of sellers to the market via expiration of lockup agreements.

Information, Expected Utility, and Portfolio Choice

“…Even on average, however, short-selling constraints could impede a symmetric negative position (see, e.g., Hong and Stein, 2003, Ofek and Richardson, 2003, and Lamont and Jones, 2002. Hence, portfolios of agents with private investors may appear to be under-diversified in the cross-section.…”

Optimal timing to invest in e-commerce

“…Ofek and Richardson (2001) contended that part of the reason for these declines has been an increase in the number of shareholder selling driven by the expiration of lock-up agreements. Garicano and Kaplan (2002) found that after the bursting of the tech bubble in 2000, in valuing B2B and B2C e-commerce businesses, the market reduced its expectations regarding future growth, the extent of transaction cost reductions, the speed of the adoption network effect, and the level of competition.…”

Bubbles, Crises, and Heterogeneous Beliefs

“…There were higher shorting interest for Internet stocks, higher borrowing costs for shorting Internet stocks, and greater violation of put call parity for Internet stocks in the options market (e.g., Ofek and Richardson (2003)). This figure is taken from Figure 5 of Lamont and Thaler (2003).…”

“…The firm insiders such as entrepreneurs and venture capitalists were initially restricted from selling their shares during the so-called lockup periods. According to Ofek and Richardson (2003), the lockup restrictions of a large number of Internet firms expired in early 2000. The subsequent selling by firm insiders put downward pressure on the share prices and caused the asset float (i.e., the number of tradable shares) of these firms to increase substantially, which in turn made short-selling of their stocks easier.…”

“…The new Internet technology provided these firms with the promise of revolutionizing the way we obtained information, purchased goods and received services. According to Ofek and Richardson (2003), an index tracking the performance of Internet stocks experienced an extraordinary growth of nearly 1000% from October 1998 to February 2000. At the peak in February 2000, the Internet sector had roughly 400 companies and was largely profitless, but commanded an astonishing capitalization of about 6% of the entire U.S. stock market.…”